Hunt for Goldilocks: Central banks are looking for neutral rates

Hunt for Goldilocks: Central banks are looking for neutral rates


Almost all central bankers in the US and Europe agree that rates must rise to cope with soaring inflation. The discussion is open where they should stop.

Monetary policy makers and markets are trying to assess where the “gold hair” or neutral level of rates lies – the optimal level for the economy not to overheat or hold back. But after almost 15 years of lukewarm inflation and ultra-low borrowing costs, no one is entirely sure what it looks like.

“Everyone is trying to understand where the neutral rate is and where the tightening cycle will end,” said Camille de Courcel, head of strategy for G10 rates in Europe at BNP Paribas. “It will be a driving force for rate markets in the coming months.”

The risk is that politicians will be wrong and let inflation spiral out of control by keeping rates too low or triggering a brutal recession by raising them too much. US central bank chief Jay Powell said he hoped for a “soft landing,” but warned last week that raising rates could cause “some pain.” Bank of England Governor Andrew Bailey spoke of a “narrow path” to keeping inflation in check without reversing growth. Christine Lagarde, President of the European Central Bank, said that “there are many challenges we still face”.

The neutral exchange rate, when price pressures cool and output approaches capacity, cannot be measured, only estimated. It is also a moving target that changes over time – before 2008 it was estimated at around 5% in advanced economies.

Fed officials believe it is now between 2 and 3 percent when inflation is at 2 percent. In their last vote, they raised interest rates by 50 basis points to 1 percent and are expected to increase borrowing costs by a further 50 basis points in each of their other two votes, so they will be on track to reach this range later this year. Others believe that the neutral rate is higher; Bill Nelson, a former deputy director of the Fed’s monetary affairs division and now chief economist at the Bank Policy Institute, estimates it is 4.5 to 6.5 percent.

The BoE believes that neutral is even lower in the United Kingdom. Their forecasts show that inflation is constantly overshooting the 2 percent target if interest rates remain at their current level of 1 percent, but does not reach this target if rates rise to 2.5 percent. This suggests that the Monetary Policy Committee believes that the right level lies somewhere between the two.

Eurozone politicians think it is getting lower. French central bank governor François Villeroy de Galhau estimates the rate at around 1 to 2 percent and compares it with “the moment you lift your foot off the accelerator when driving close to the required speed.”

There are growing concerns that neutral may not be enough. Behind closed doors, officials are increasingly worried that their economies are now so hot that rates will have to step on the brakes. Inflation, which has now peaked on both sides of the Atlantic in a decade, could turn out stronger than expected and force the economy into a deep downturn, as Fed Chairman Paul Volcker did in the early 1980s when he raised rates federal funds. at 20 percent. Vicky Redwood, a former BoE executive who is chief economic adviser at Capital Economics, said: “If high inflation has taken root more than we think, then a Volcker-style recession is likely to be needed.

Krishna Guha, a former Fed employee who is now vice president of the Evercore ISI, said the question facing all central banks was: “Will you be forced to go at a neutral rate, even if you have to go back once inflation is subdued? “.

Powell said on Tuesday that the Fed would “not hesitate at all” to raise rates above neutral if inflation remained high, adding that officials “with no confidence” do not know where neutral is. “In the first phase, they will try to get back to neutral and then evaluate,” said Jean Boivin, a former central banker in Canada, now at BlackRock, predicting that at that moment, “the world will be very different from where it is right now.” .

As Wednesday’s figures show that British inflation will hit new highs by April, the BoE – which has raised rates three times this year – is under tremendous pressure to speed up its response. Michael Saunders, one of the MPC’s hawks, said the central bank would have to move “relatively quickly to a more neutral stance,” although there was little indication that rates would need to be raised beyond that.

Lagarde has made it clear that the ECB, which has not yet raised its deposit rate from minus 0.5 percent but is expected to do so for the first time in ten years in July, aims to “normalize” rather than “tighten” monetary policy, towards to a neutral rate, but not for it.

Last week, the President of the ECB signaled that the ECB had rushed less than the Fed to achieve neutrality, saying: “The normalization process will be gradual.” However, Dutch central bank chief Klaas Knot became the ECB’s first chief executive on Tuesday to raise the prospect of a half-point rate hike in July, rather than a quarter-on-quarter increase that is widely expected.

In addition to being more exposed to the conflict in Ukraine, the ECB is also hampered by the risk that the cost of borrowing will take place in heavily indebted southern European countries such as Italy.

The spread between Italy’s 10-year borrowing costs and German borrowing costs has become the widest since the pandemic shocked the debt markets in 2020.

While some ECB officials spoke of launching a “new instrument” to address this risk, Guha said “the spread could crack and force the ECB to set a time limit for raising rates”.



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